Saudi Arabia declared an all-out war of attrition on oil prices, marking the end of a long, fruitful relationship between two of the largest producers of oil in the world. A mutually beneficial relationship between Moscow and Riyadh began in 2014, when U.S. shale oil began flooding oil markets around the world. Increased supply from the U.S. meant that oil prices declined by 70%, in what the World Bank has called the longest lasting period of declining oil prices since 1986. This paved the way for The Organization of the Petroleum Exporting Countries (OPEC) to sign deals with its non-member petrostate allies, led by Russia, to drastically cut production in order to sustain higher prices. These deals are generally referred to as OPEC+. According to Forbes, OPEC’s 14 members control 35% of the world’s oil supplies and 82% of proven reserves. The inclusion of OPEC+ implies that this super-cartel now controls over 55% of the world’s oil supplies and 90% of proven reserves.
The enormous influence of OPEC+ on the global oil markets implied that both Saudi and Russia were able to successfully maintain a price floor on oil prices by limiting their production of oil. This allowed all the members in this super-cartel to profit from collusion. However, the relationship soured early last month when OPEC failed to strike a deal with its allies led by Russia. Moscow refused to join OPEC in implementing large-scale production cuts, amidst an environment of economic slowdown driven by the Covid-19 crisis. Instead, Russia wanted to produce more. According to CNBC, OPEC’s proposal was conditional on support from its non-OPEC allies, including Russia.
“It is truly a go big or go home moment for this organisation. If Russia says no today. There are real questions about the viability of the OPEC+ arrangement,” Helima Croft, head of commodities strategy at the Royal Bank of Canada Capital Markets, to CNBC reporter Dan Murphy.
Russian Energy Minister Alexander Novak told reporters that the disagreement between Russia and OPEC implied that members could produce what they liked from April 1st. “We have made this decision because no consensus has been found of how all the 24 countries should simultaneously react to the current situation. So as from April 1, we are starting to work without minding the quotas or reductions which were in place earlier, but this does not mean that each country would not monitor and analyse market developments.” Russian Energy Minister to reporters after leaving a meeting with OPEC in Vienna early last month.
Since Russia’s refusal of the proposal, Riyadh decided to teach Moscow a lesson by initiating the chicken game with Moscow. The chicken game is a model of conflict in game theory, wherein the ideal outcome would be for either party to yield however, neither does so out of fear of being a ‘chicken’. Both countries now are rapidly increasing their supply of oil to price each other out of the market. Riyadh and Moscow would both benefit from ending the chicken game, however, neither would prefer to yield to ensure that they teach a lesson to each other.
Both countries have the resources to continue engaging in a protracted chicken game. According to Again Capital’s John Kilduff, “the Saudi’s are the lowest cost producer by far,” which demonstrates their unique ability to withstand a sustained period of decreasing oil prices. The World Bank’s data also demonstrates that both the Saudi’s and the Russians have significant foreign exchange reserves, at US$509.469 billion and US$468.645 billion, respectively. Foreign exchange reserves are crucial in this case because it allows countries to finance their imports and debts; without these reserves, economies can grind to a halt. Both countries also have significant sovereign wealth funds, which can help Riyadh and Moscow sustain this price for even longer. The Public Investment Fund of Saudi Arabia, according to the SWF Institute, is currently estimated to hold assets worth US$320 billion while the Russian National Wealth Fund, according to the Ministry of Finance of Russia, is estimated to hold assets worth US$124 billion. It seems that American shale oil producers will be the ones that will bear the brunt of this price war, with both Riyadh and Moscow pricing them out of the market.
A key factor driving this price war is the overarching juxtaposition in strategic interests between Russia and Saudi Arabia. Russia’s hydrocarbon exports are concentrated in a few discrete markets. 70% of Russian oil exports went to countries in Europe and 18% to China in 2016, according to the U.S. Energy Information Administration. Contrarily, Saudi Arabia maintains an extensive network of global clients, helping them hedge against risk and volatility better than Moscow. Therefore, the primary concern for Russia is to maintain market share in the few markets that it exports its hydrocarbons to. Cutting oil production in-line with Russia’s former allies at OPEC would imply increasing oil prices. This would provide the U.S. an opportunity to increase the production of its shale oil in order to flood Russia’s key export markets with American oil, to the detriment of Moscow’s interests.
According to The New York Times, Russia’s concerns with American oil were further exacerbated by Washington’s sanctions on Moscow’s state-owned oil company Rosneft in February this year. These sanctions were designed to create a “campaign of pressure” against the Venezuelan President Nicolás Maduro, said Elliott Abrams, special envoy for Venezuela policy at the U.S. Department of State. President Maduro uses Rosneft’s shipping infrastructure to export 70% of its oil, in a bid to circumvent America’s sanctions on Venezuelan exports. The U.S. claims that President Maduro uses profits from exporting oil through Rosneft to help himself remain in power, hence the sanctions on Rosneft.
“Rosneft will now have to think how much Venezuela is worth from a business standpoint, compared to the costs of remaining under sanctions,” said Francisco Monaldi, a Venezuela energy expert at Rice University. However, as is evident by the current war on oil prices, sanctions on Rosneft have backfired on the Americans. The sanctions have further bolstered Moscow’s determination in maintaining its market share in its key export outlets. This renewed determination has provided Russia the motivation to engage in a protracted chicken game with Saudi Arabia to teach both Riyadh and Washington a lesson.
Normally, tumbling oil prices imply an economic boost in the global economy, due to lower input prices for goods and services. However, the ongoing Covid-19 crisis has also created a significant negative demand shock in the global economy. “Highways are empty. Planes are grounded. Factories are dark,” Matt Egan, lead writer at CNN Business. The world’s thirst for oil has evaporated. There is nowhere for all this surplus oil to go other than in storage. However, a sustained price war between Riyadh and Moscow would imply that storage for oil would also soon be depleted, which would result in negative oil prices. According to CNN Business, some obscure grades of oil have already fallen to sub-zero prices. For instance, Wyoming crude grade was bidding at negative 19 cents/barrel in late March.
“The price is trying to go to a level to force companies to keep the oil in the ground. If it has to go to negative to incentivise that behaviour, then it will,” Jeff Wyll, senior energy analyst at Neuberger Berman, an investment management firm. Therefore, the prospect of negative oil prices in the near future will ultimately push both countries to end the game of chicken they are currently engaged in with oil prices.
Concluding, strategic differences between Russia and Saudi Arabia has driven an oil price war between the two countries for the past few weeks. Russia is determined to increase its oil supply to maintain market share and price U.S. shale oil out in its key export markets. While Saudi Arabia is determined to reduce its oil supply in order to maintain the current level of profits, factoring in the negative demand shock from the Covid-19 crisis. Ultimately, the prospect of negative oil prices will eventually push both countries back to the negotiating table, leading to an end to this destructive game of chicken.
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